ABSTRACT
As discussed in earlier chapters, there has been since the early 1990s a growing consensus that, for a developing country like Indonesia, the key role of monetary policy is the maintenance of price stability, meaning ‘low and stable inflation’. Monetary policy conducted to maintain price stability over the medium term is important for, or essential to, sustained steady economic growth. No consensus has, however, yet emerged on any particular preferred strategy of monetary policy to maintain price stability. A range of alternative strategies has been adopted by different countries at different times. Until the early 1970s, the strategy of most countries under the Bretton Woods system was exchange-rate targeting. Following the purchasing power parity condition, the fixed exchange rate of a country’s currency against the US dollar acted as a nominal anchor for prices in that country. This might have worked for some smaller countries but did not work for Indonesia, a larger country with a relatively substantial nontradable goods sector. When the Bretton Woods system collapsed in the early 1970s, some developed countries opted for a floating exchange-rate system. This policy shift required them to replace the exchange rate with an alternative nominal anchor for price stability (Cagliarini et al., 2010). Consequently, monetary targeting became the strategy of choice for some developed countries, especially through the global high-inflation experience that began in the early 1970s and extended into the mid-1980s. However, financial deregulation and financial innovations that started in developed countries in the mid-1970s arguably caused instability in the money-demand function, weakening or severing the link between money supply growth and inflation. Goldfeld (1973, 1976) first identified the ‘missing money’ episode for the United States. Later, a series of empirical studies suggested the breakdown of the money-demand relationship for other developed countries (Goldfeld and Sichel, 1990). Consequently, monetary targeting lost its appeal in the late 1980s as a strategy of monetary policy, especially in developed countries. 1
